As the economic turmoil begins to calm, Andy Baldwin considers the lessons to be learned, such as keeping a more careful eye on our capital
Is it too early to start drawing lessons from recent times? The global economy seems to be taking the first tentative steps towards recovery: the UK and the broader Eurozone look set to return to growth, albeit at a low, almost anaemic level; the global financial system is starting to display levels of normality; and the insurance industry weathered the crisis well compared to other sectors.
With the worst hopefully behind us, the post mortems can at least start with a focus on what lessons we can learn from the past 18 months.
Even at this early stage, it’s clear that the recession has provided a chilling reminder that insurance businesses have exposures well beyond the risks assumed from their insurance policies. Possibly the most important lesson is that, in a world of highly integrated and interdependent financial systems, the extreme 1:100 year risk events can catch even the most well-prepared businesses off balance.
So what do insurers need to do? As a starter, comprehensive upfront planning and capital management strategies will enable companies to be better prepared to anticipate, manage and respond effectively to major future stress events.
The downturn, along with new solvency rules, revealed that sensitivity to regulatory requirements could be a major challenge to many organisations. Insurers that relied on consolidated, enterprise-wide measures of risk and capital are now recognising that capital that appears available to the enterprise may not be accessible in times of stress.
It is hugely important to proactively monitor regulatory and rating agency capital requirements at the local operating company level and have clear plans in place for how capital can be moved from one company to another during a crisis situation.
At the height of the credit crunch, liquidity challenges came from many directions: parent company cashflow needs; cash collateral to
back specific investment positions; illiquid investments; and the inability to sell publicly traded securities for their perceived intrinsic value.
Thankfully, insurers are now moving beyond the immediate need to preserve and bolster liquidity and are now focusing on long-term liquidity risk measurement and retaining earnings to bolster capital levels.
The new challenge for insurers is generating or raising capital over and above the amounts predicted by economic capital models. Easier said than done, but this means reassessing capital modelling and revamping the capital management and treasury functions of many insurers – historically an under-invested and frequently overlooked function – as they take the lead in ensuring a robust investment strategy with sound mitigation processes to fully understand and critically evaluate contract and counterparty risks.
This may require more advanced techniques of dynamic capital forecasting, scenario testing and financial risk assessment via scenarios, but, ultimately, businesses are likely to emerge more robust as a result.
A comprehensive review of the overall risk strategy and supporting management processes is central to this. The good news for many insurers is that the insurance risk strategy (what risks to write and at what level) and operational risk (internal risks such as outsourcing and offshoring) performed well overall. It was in the areas of market risk (what you have invested in) and credit risk (who owes you money) where the financial crisis placed the greatest strain and where the impact was felt strongest by insurers.
Over the coming months, we will see insurers revamping and renewing their enterprise risk framework. It’s no coincidence that diversified insurers with strong risk management fundamentals performed well in recent months.
Successful enterprises are able to rely on core operating profitability to steel themselves against extreme events and take advantage of competitor weakness. For all insurers, properly utilised economic risk and capital measures are powerful tools for understanding their financial position and for developing sound risk management strategies. Upgrading capital management and embedding economic capital measurement and allocation into the business model should be a key activity for insurers right now.
No insurer can future proof their business, but a critical step in shaping up for the future is revamping the risk management framework and ensuring the risk governance model is appropriately defined and cascaded through the business. This presents a particular challenge to the insurance industry due to the breadth and complexity of the risks involved. It is simplistic to assume that a standalone risk function led by a chief risk officer will somehow be omnipresent for each and every exposure facing the business.
Critical to ensuring that risk is appropriately managed at the board level will be a consistent, accurate data set used to support insurance, credit, market and operational risk management decisions across the business. In the future, there will be greater focus on relevant “what if” scenarios and reporting early warning signs or movement in lead indicators. Businesses have learned that it is worth preparing for the unthinkable.
For leading insurers, the focus for the past year has been on tightly managing their business and protecting their capital base. But the leading players are now refocusing on a growth agenda that will reshape their organisations and guide them in the future. Excellence in capital and risk management is not just about getting out of the current downturn unscathed, but is also about positioning your business to make the most of the lessons learned this time around. IT